Hot ‘dividend dogs’ take world stocks by the tail

Opinion: High-yield strategy’s success in U.S. is translating overseas

By

Conradde Aenlle

One of the simplest, most effective ways to beat the U.S. stock market over the long haul has been with a “Dogs of the Dow” strategy.

Just hold equal dollar amounts of the 10 constituents of the Dow Jones Industrial Average
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with the highest dividend yields and rebalance at least annually.

A Dogs exchange-traded note, Elements DJ High Yield Select 10
DOD, -0.10%
, had a cumulative total return — share price appreciation plus dividend income — of 183.3% in the five years through April 25. That was comfortably above the 138.1% return of the SPDR S&P 500
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the exchange-traded fund that tracks the S&P 500.

A sensible explanation for the outperformance is that investors are buying into blue-chip companies which have solid enough earnings to return healthy dividends to shareholders every quarter, but whose shares also trade at cheap prices (these stocks are called Dogs because high yields often get that way after a stock has suffered). A long track record — the ETN has been around since 2007 and the idea behind it goes back much further — shows that the Dogs approach works.

But how will foreign breeds do?

Two ETFs introduced in the last year attempt to transport the Dogs approach overseas. ALPS International Sector Dividend Dogs (IDOG)
IDOG, -0.14%
, launched in mid-2013, focuses on foreign developed markets and invests in the highest-yielding stocks in each of the various business sectors that analysts carve the economy into.

The second ETF, ALPS Emerging Sector Dividend Dogs (EDOG)
EDOG, -0.16%
, began trading in late March and does more or less the same thing in the developing world. Both funds allocate assets to sectors in equal weights and without regard to geography, as long as a market is developed or emerging, as the case may be. The portfolios are rebalanced quarterly to return them to equal sector weights.

Over the six months through April, IDOG has produced a total return of 7.9%, versus a 4.6% gain for iShares MSCI EAFE
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, an ETF that tracks the MSCI Europe, Australasia and Far East Index, a benchmark for foreign developed markets. Meanwhile, EDOG, which came to market in late March, rose 2.8% in April, topping the benchmark iShares MSCI Emerging Markets
EEM, -0.27%
by two percentage points.

Do these auspicious beginnings indicate that the Dogs funds are worth owning? The approach has worked well for years in the U.S. market, despite the tendency of successful investment strategies to have their strength diluted over time, and there’s no reason to think that the dynamics of other markets would be sufficiently different to alter the usefulness of a Dogs portfolio.

One thing for prospective buyers to consider is that the returns of IDOG and EDOG, relative to conventional benchmarks, will be driven by three separate strategies, making them mixed breeds. First, there’s the Dogs focus on dividends and low valuation.

Then there’s the portfolio rebalancing, which is a strategy all on its own. Investors are often encouraged to sell some winners and buy more of their weaker performers periodically as a way of systematically emphasizing value.

By equal-weighting sectors, the funds are implementing a third strategy similar to the ones used by so-called smart-beta funds. They try to outperform traditional capitalization-weighted indexes by altering the proportions of component stocks in standard ways that are thought to produce long-term outperformance. Here again, equal-weighting is a way to concentrate on stocks with lower valuations because it results in smaller — and, the managers presume, undervalued - stocks being held in greater proportions.

Because the three strategies stress value, there’s always a risk of comparative weakness when value underperforms, such as when momentum is ascendant — investors buying whatever is going up.

But those periods don’t last forever, even though it can seem like forever to value investors at the time. It’s too early to draw conclusions about their return potential, but for conservative investors who want exposure to foreign stocks for the long term, the Dogs probably will remain faithful to them, too, and won’t turn around and bite them.

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